From the Peanut Gallery

We are just about finished with the August economics marathon.

In my earlier post Economics 202: Artificial Limits on Supply – Housing, I argued that one factor leading to the ever-increasing cost of housing was government actions, such as zoning restrictions, that tend to limit supply. Another government program, the mortgage interest deduction,((just in case the reader is not certain what the mortgage interest deduction is: in general, a taxpayer who itemizes deductions may deduct from adjusted gross income the interest paid on money borrowed to buy or improve the taxpayer’s residence, so long as the loan is secured by a mortgage on the property.)) acts as a demand-side subsidy((The mortgage interest deduction is what is sometimes called a “tax expenditure,” which means that the government does not actually incur an expense but foregoes revenue, which has the same effect.)) and contributes to the increase in housing costs.

“Wait,” you may say, “I thought the mortgage interest deduction benefits homebuyers and makes buying a house more affordable.” I long thought so myself and supported the mortgage interest deduction as a way to encourage home-ownership. However, I have recently concluded, consistent with the earlier examples of the effects of demand-side subsidies, that it does not really work that way. When a homebuyer (and her lender) is calculating the mortgage amount she can afford (which, when added to the down payment, is, less closing costs, the maximum she can pay for a house) she is looking at the monthly payment. The deductibility of mortgage interest means that the mortgage payment can be that much higher, increasing the gross amount that can be paid in debt service and therefore the amount that can be borrowed. In a seller’s market, the buyer will be forced to the upper edge of her affordability envelope (if she does not choose to go there, one of the other potential buyers certainly will). Thus, the true beneficiary of the mortgage interest deduction is the home seller.

Because I do not believe that there is any general social benefit to using a tax expenditure to keep housing costs as high as they are, I have concluded that the mortgage interest deduction should be discontinued. Because, however, millions of homeowners took the deductibility of mortgage interest into account in determining how much to borrow, it could be catastrophic (and certainly would be unfair) to take the deduction away all at once. I would like to see it ratably reduced over a span of 25 or 30 years.((Under the 25-year plan, in year 1 96% of mortgage interest (including new mortgages) would be deductible, in year 2 92% and so on until zero deductibility is achieved in year 25.))

Jay Bohn
August 30, 2021

As I have said several times, I do not claim to have originated the concept that demand-side subsidies increase the price of the subsidized commodity. In the area of higher education I can confidently point to someone who still may not be first, but certainly got here ahead of me: former U.S. Secretary of Education William Bennett. His 1987 New York Times op-ed articulated what became known as the Bennett Hypothesis: “increases in financial aid in recent years have enabled colleges and universities blithely to raise their tuitions.”

In 2016 Grey Gordon and  Aaron Hedlund published a working paper “Accounting for the Rise in College Tuition” which summarizes some research on this question and proposes a model that indicates that “demand shocks—which consist mostly of changes in financial aid—account for the lion’s share of the higher tuition.”((Another collection of studies appears here, and provides this alarming statistic: “Between 1978 (the first year in which college tuition had its own CPI category) and the third quarter of 2017, the price of tuition and fees increased by 1,335 percent. This rate of growth exceeded that of medical costs (704 percent), new home construction (511 percent) and the Consumer Price Index for all items (293 percent). [footnotes omitted]”)) What would happen if the government (meaning taxpayers) provided free tuition as Bernie Sanders and other “progressives” propose?

As with any other vendor, the college wants to maximize its revenue (for only the best of motives of course). Colleges compete for students in more ways than academic prestige; I would bet student living is significantly more comfortable than in the past. The cost of tuition is less an immediate consideration. Indeed, higher tuition may be a status symbol and a surrogate for the quality of the education.

Here, as in other sectors, there exists a group of students who (or perhaps more accurately, whose parents) can afford and are willing to pay without subsidy. Others must receive financial aid (financed in part no doubt by those paying full freight). It has become impossible to save or work one’s way through college.

Jay Bohn
August 26, 2021

This is the first of a three-post arc discussing the impact of demand-side subsidies upon particular areas of the economy that will bring the August economics marathon to an end.

In the post Economics 151: Insurance Basics and the Affordable Care Act, I noted that health insurance has grown in the scope of benefits offered; it is no longer just protection against the cost of a catastrophic illness or injury but pays for a significant portion of routine medical care including office visits, physical examinations and prescriptions. It has long been my premise that the availability of a source of ready payment for such services means that the cost of the services will increase to absorb available funds. The insured rarely shop for healthcare based on price because the deductible/co-payment will either be a fixed amount or relatively insignificant and somebody else is paying for the balance. Health insurance itself acts as a demand-side subsidy.

The substitute for the price-conscious consumer is the insurance company itself which will ration care and/or dictate what healthcare providers are paid. Insurance companies are not the fan-favorite in this competition. As with many other areas where demand-side subsidies are offered, the policy emphasis is on the consumer’s “need.” This process will lead to government mandates that certain benefits be provided (meaning that insurance companies will have to look to patients with less “popular” conditions for savings). There are also problems where the service is provided by a healthcare practitioner not contractually tied the the insurance company’s reimbursement rates but where the government protects the patient from full responsibility for the cost of care from the non-participating practitioner.((See here for an early explanation of New Jersey’s then-new law on the subject.))

Jay Bohn
August 23, 2021

This is the post I have been planning since the first on economics in the beginning of May. I will start by repeating that I am not an economist and that I do not claim credit for “discovering” the principle I am asserting.((Not being an economist, I also do not feel obligated to do research to trace the history of this idea.))

One of the basic building blocks of economics is the “law” of supply and demand that I wrote about some months ago as one of the basic premises for my ideas. My last two posts((Economics 201: Artificial Limits on Supply and Economics 202: Artificial Limits on Supply – Housing)) considered this from the supply side, particularly the effect of artificial supply limits (government regulations) on prices.

Now I am looking at it from the demand side. In my supply and demand post I asserted that “demand” includes, but means more than, mere “want” or “desire” for an item.  The consumer must be able to pay for the item, an ability I called “wherewithal.”

Where a particular economic commodity is important, but unattainable for many due to price, it is common for politicians to propose to subsidize its purchase by those who cannot afford it. A couple of examples will suffice: college education and housing.

If you have been paying attention (and accept my thesis about desire and wherewithal constituting “demand”), you see where this is leading: broad-based demand-side subsidies tend to cause the price of the subsidized commodity to increase. Further support for this proposition comes from what I described as the SEP Problem: the fact that “someone” else is paying for something can have the effect of increasing the cost that thing, especially where “someone” is someone of whom the consumer is willing to take advantage (the government or insurance companies, for example).

This principle does not necessarily mean that broad-based demand-side subsidies are inherently wrong, just that they are inefficient. The price for the good is a moving target, just as the “observer effect” in physics posits that the act of measuring can change the state of the thing measured. A government program that seeks to make automobiles more affordable may decide that giving potential buyers $400 to use to purchase a new (or newer) car, say in exchange for a “clunker” of no real value, will allow a reasonable number of households to acquire safe, fuel-efficient and ecological appropriate automobiles (or at least better than the clunkers traded in). However, automobile prices are nothing if not elastic, and there is no guarantee that the “base price” of the car that the consumer is seeking to purchase was not recently raised to absorb the benefit of all or most of the $400 subsidy.

Eligibility for the subsidy may be means-tested to assure that those who can afford the item are not subsidized, but just as it will reduce the government’s cost for providing the subsidy, it will also result in actual higher prices for those whose purchase of the commodity is not subsidized.

My next several posts will provide examples of this principle at work, in healthcare, higher education and housing.

Jay Bohn
August 19, 2021

In my last post I commented on the effect of artificial limits on supply (mostly government regulations) as a cause of higher prices. In this post I will deal with one example, the effect of government regulation on the cost of housing.

It is quite common to blame builders for the increasing cost of housing. While I do not doubt that builders seek to make as much profit as possible from every housing unit they construct,((Indeed, go back to the thesis of my very first economics post: “My thesis is that as a general rule people will tend to act in what they perceive to be their (economic, political, social) best interest.”)) there are other forces at work.

One of these factors is demand. As the population increases, the number of households seeking housing increases as well. We are in the midst of a remarkable sellers’ market with housing selling for a significant premium over the (presumably already inflated) asking price.((Demand is also influenced by the availability of financing and low interest rates, but I am anticipating just a little bit; stay tuned.))

Another factor, however, is the limits that government (chiefly local government) puts on their ability to build large amounts of housing.

In the early part of the twentieth century, municipal zoning became widespread. The earliest forms may have simply attempted to segregate residential, commercial and industrial uses from each other, but municipalities soon learned that they could use the zoning power to exclude the poor and minorities (who are over-represented in the lower income levels) by, among other things, prohibiting or severely limiting multi-family housing and requiring relatively large lot sizes.

Decades ago builders could provide housing affordable to working families without subsidies and set-asides (think Levittown).((A single house on a large lot may yield a profit, but as the number of houses on the same size tract increases, I am certain that the aggregate profit increases as well (at least to a point), even though the price of each home will be less and therefore affordable to a larger portion of society.)) But as the easily developed land was used up, it became harder for the free market, even where permitted to do so by appropriate zoning, to provide such housing. Exclusionary zoners, at least in New Jersey, have done a pretty good job of running out the clock on the ability of market forces to provide affordable (in the generic sense) housing for households of modest incomes.

But for every government-created problem, there is likely a government-proposed solution, with a significant premium in transaction costs and control.

In 1975 the New Jersey Supreme Court found in the State constitution a limit on municipal ability to use the zoning power to exclude poorer households. In fact, it determined that municipalities had an affirmative obligation to use their zoning power to provide a realistic opportunity for their fair share of housing affordable to lower income households. This ruling did not prohibit the use of the zoning power to exclude the poor by increasing housing prices, it just limited it. Over the ensuing 45+ years there has been much litigation over the details.

It is not my intention here to discuss the myriad failings along the way, I just want to point out that “affordable” has become a term of art and, like so much else, those not wealthy or not poor enough to qualify for the government benefit are squeezed out.

Jay Bohn
August 16, 20201